Search brisbanetimes:

Search in:

Off limits, but blessed by the Fed

Gretchen Morgenson

Documents show how the Fed gave JPMorgan Chase a free hand to expand in businesses like electricity that are typically off limits to big banks. Photo: Reuters

The good news arrived in a confidential letter from the Federal Reserve Board in Washington. The nation’s biggest bank, JPMorgan Chase, had won the right to expand its reach in a lucrative business that has nothing to do with banking: electricity.

Areas like electricity are generally off limits to banks because of the risks involved. But with its June 2010 letter, the Fed let JPMorgan take an even bigger role selling electricity in California and the Midwest, saying the push would “reasonably be expected to produce benefits to the public that outweigh any potential adverse effects.”

Three months later, JPMorgan traders began a scheme to manipulate electricity prices, ultimately forcing consumers in those regions to pay more every time they flicked on a light switch or an air-conditioner, the Federal Energy Regulatory Commission subsequently contended.

The story of how the Fed cleared the way for JPMorgan — a decision that brought many millions in profits to the bank — illuminates how the Fed has allowed the bank into a variety of markets for basic goods. Since 1956, a federal law has limited banks’ involvement in physical commodities. But confidential documents, many obtained under the Freedom of Information Act, show that since 2005 the Fed has granted three special exemptions to JPMorgan Chase alone.

In 1999, Congress permitted Wall Street investment banks like Goldman Sachs and Morgan Stanley to keep their commodity operations. Since then, other banks have been allowed to expand into commodities, but in recent years no bank has gotten more leeway from the Fed than JPMorgan, experts in the field contend. In California and the Midwest, JPMorgan’s subsequent dealings in electricity echoed actions of Enron a decade earlier. The Federal Energy Regulatory Commission contended that JPMorgan engaged in price manipulation that generated $125 million in “unjust profits.” Last July, JPMorgan agreed to pay $410 million in penalties and restitution; it neither admitted nor denied wrongdoing.

Maneuvering in markets for electricity, metals, oil and more added billions to the bottom line at banks like JPMorgan, Goldman Sachs and Morgan Stanley in recent years. But their involvement in commodities has now come under intense scrutiny. Industrial users of aluminum and other metals contend that questionable activities by major banks have increased their costs. Regulators like the Commodity Futures Trading Commission have been investigating the issue, and congressional hearings have also explored potential problems.

Amid this heightened scrutiny, the Fed said last July that it would review its recent decisions to let banks expand their commodities operations. A ruling is expected early next year. A Fed spokeswoman declined earlier this month to comment further. JPMorgan, for its part, has scaled back its activities in the electricity market and, last summer, said it was putting its entire commodities unit up for sale. The decision comes as prices — and profits — have fallen in the commodities arena.

The opposite held true in 2005, when banks began asking the Fed for the right to expand into commodities trading. The banks argued that this business was complementary to their financing operations and thus should be allowed. The Fed agreed.

In these rulings, the Fed consulted the Bank Holding Company Act, a 1956 law designed to protect banks and the financial system from risks associated with nonfinancial activities. The basic idea is that for banks, some businesses are simply too risky. An institution that owned oil tankers, for example, might be threatened by the costs associated with a large oil spill.

And so, between 2005 and 2008, the Fed allowed seven banks, most of them foreign, to expand their commodities activities, but in a limited way. They could trade commodities contracts and could also take delivery of physical goods — such as natural gas and crude oil — to satisfy those arrangements. Previously, taking such deliveries had been disallowed.

But in these rulings, the Fed barred the banks from owning or operating physical commodities businesses, like storage warehouses, pipelines or other transportation facilities. United States banks subject to the restrictions were JPMorgan Chase, Citibank and Bank of America.

Privately, however, eight confidential letters between the Fed and JPMorgan show the regulator taking a more accommodative approach. The letters, which were obtained by The New York Times, show how the Fed gave the bank free rein to push into commodities time and again. It has let JPMorgan expand in areas like electricity tolling agreements, where the bank essentially took over a power plant, providing its fuel and selling its output. And since 2010, the Fed has also allowed the bank to own and operate Henry Bath & Son, a big metals storage company, the type of operation it had barred the bank from owning in 2005.

Since 2012, the letters show, JPMorgan has twice appealed to the Fed to let it keep Henry Bath, succeeding both times. As recently as last July, the Fed granted the bank an extension — until July 2014 — to meet banking law requirements or sell the company. In the three years that JPMorgan has owned Henry Bath, it has generated $161 million in profit for the bank.

“With the big banks, everything is negotiated,” said Edward J. Kane, a professor of finance at Boston College and an authority on regulatory failure. “The rule provides a constraint on the negotiation, but ultimately the Fed and these banks are married. They are, day after day, dealing with each other and as in a marriage you almost never issue an ultimatum.”

Back in 2005, when the Fed prohibited JPMorgan from owning storage and transportation facilities, it did so to “minimize the exposure of JPMChase to additional risks, including storage risk, transportation risk, and legal and environmental risks,” it said in a Fed order published that November.

But then, in 2008, when Bear Stearns collapsed into the arms of JPMorgan during the financial crisis, JPMorgan inherited the investment bank’s commodities business. Two years later, JPMorgan acquired Sempra Commodities, a global giant in oil, metals, coal and power, from another troubled bank — Royal Bank of Scotland.

“This acquisition extensively expands our global commodities capabilities, enabling us to extend our reach in the commodities space dramatically,” said James E. Staley, then the head of JPMorgan’s investment bank, said at the time. “This addition is a great fit for our business as it helps us further serve our clients.”

As part of that $1.6 billion deal, JPMorgan acquired Henry Bath. Headquartered in Liverpool, England, Henry Bath stores copper, aluminum, nickel, tin and zinc at warehouses in Italy, the Netherlands, Singapore, Turkey and the United States.

Just a few years earlier, the Fed objected to the ownership of Henry Bath by Royal Bank of Scotland and ordered it to sell. But the Fed allowed JPMorgan to buy Bath and fold it into its operations.

Josh Rosner, a financial services analyst at Graham Fisher who provided The Times with one of the Fed’s approval letters, questioned the Fed’s flip-flop in which it disallowed Royal Bank from owning Henry Bath but let the bank sell it to JPMorgan. “The Fed seems to have been picking winners and losers,” he said.

In the summer of 2010, commodities markets were hot, and JPMorgan wanted a bigger piece of the action in this highly profitable arena. Unlike investment banks such as Goldman Sachs and Morgan Stanley, whose commodity operations had been deemed permissible by Congress in the Gramm-Leach-Bliley Act of 1999, JPMorgan Chase had to get approval from the Fed to go deeper into commodities.

Such Fed decisions are usually kept confidential, and it is unclear why the Fed allowed the bank to expand.

A JPMorgan spokesman declined to comment on private communications with the Fed. But according to letters received under the Freedom of Information Act, the Fed cited a section of the Bank Holding Company Act that allows the purchase of operations if they are largely financial — and not physical — in nature. The approval came with a condition: If JPMorgan did not restructure Henry Bath to meet certain requirements of the banking law within two years, the bank would have to sell the storage facilities.

JPMorgan neither reduced Henry Bath’s physical commodities focus, nor divested it. In April 2012, two top bank executives, Blythe Masters, the head of JPMorgan’s commodities unit, and Francis Dunleavy, head of its principal investing group, joined Henry Bath as directors. (Mr. Dunleavy was identified in the FERC manipulation case and has resigned from JPMorgan and Henry Bath’s board.)

Then, just two days before the two-year grace period was up, JPMorgan wrote a letter asking the Fed for another year to meet the requirements of the law. The letter, sent to Ivan J. Hurwitz, a vice president for bank applications at the Federal Reserve Bank of New York, said JPMorgan was requesting the extension so it could “complete the necessary steps to conform its holding in Henry Bath to the requirements of merchant banking.”

Merchant banks are not subject to the same commodities prohibitions as commercial banks.

Four months later, the Fed granted JPMorgan’s request, letting the bank hold the company until July 1, 2013. The Fed required that the bank provide it with quarterly reports outlining actions it was taking to divest or restructure the business.

In March 2013, a letter from JPMorgan to the Fed noted that discussions with potential buyers of Henry Bath were continuing. The bank also said it had discussed shifting the storage of metals held in Henry Bath warehouses to reduce the percentage of metals owned by the bank itself and held in its own facility. Such a reduction would help JPMorgan conform to banking laws that restrict the size of a bank’s holdings in physical commodities.

“We are working actively to achieve the results stated in the letter and will keep you apprised of our progress,” the bank said in the letter.

But on May 1, the bank wrote a letter requesting a second yearlong extension.

“This extension will provide time for JPMC to continue efforts to divest its interest in Henry Bath,” the bank said.

The Fed granted the second extension in a letter dated July 11, 2013. JPMorgan had “taken substantial measures during the extension period to conform or divest the remaining activities of Henry Bath,” the Fed said. Another extension “is appropriate in view of these good faith efforts.”

The nature of those efforts is not clear from the documents.

The timing of the communications between JPMorgan and the Fed suggests that the bank viewed the regulatory approval on both its proposed electricity expansion and the Henry Bath purchase as a fait accompli. For example, its request to enlarge its electricity business was made to the Fed on Dec. 30, 2009 — after it had already contracted to add two power plants to its operations.

The plants figured in the manipulation case that FERC filed against JPMorgan last summer. Investigators for the commission found that from September 2010 to November 2012, bank officials engaged in a dozen electricity bidding strategies aimed at wringing profits from the high-cost and inefficient power plants it controlled. The bank’s bids created artificial market pricing, forcing customers to pay premium rates, the regulator said.

Saule T. Omarova, a professor of law at the University of North Carolina, Chapel Hill, is critical of banks’ expansion into commodities, which the Fed has blessed.

“By allowing this expansion into tolling and energy contracts, it really expands the power of JPMorgan to influence markets and market prices,” Ms. Omarova said. “The Fed seems to be completely incapable of embracing the concerns over market power and potential market manipulation and systemic and concentration issues.”